Robos survived a volatile year. What happens when it's worse?

Buoyed by a decade-long bull market, robo advisory firms have made significant inroads in the U.S. wealth management market since the financial crisis — assets on digital platforms are now expected to top $1 trillion by next year.

But 2018’s shaky performance suggests the young upstarts may have an Achilles heel. The vast majority of digital firms have not experienced a full market cycle. Fears are rising about how the tools will perform in a downturn. In a slumping market, will clients continue to invest in automated platforms that almost exclusively track passive investment products?

“We do worry that without access to an advisor, robo clients will have emotional reactions to a bear market or succumb to pressure to adjust to what they believe will best retain assets,” says Craig Birk, CIO of hybrid robo advisor Personal Capital. “We see that robo clients are already quick to turn the dial up or down, and we expect this will accelerate in a true bear market.”

Client behavior during recent technical glitches may be portents of what could come during a sharp downturn. In February, a handful of wealth management websites went dark when firms couldn’t handle unusually heavy user activity after a particularly turbulent two days of trading. As the market plunged 1,175 points, clients wanted access to their assets.“While the strategy of low-cost diversified portfolios can be compelling, it is the behavioral component that could be a problem for robos in the next market correction,” says James Gambaccini, CEO of Reston, Virginia-based Acorn Financial. “You don’t need to look far for warning signs.”

In fact, digital platforms reported losses in turbulent 2018 — the first down year many automated platforms ever experienced. Portfolios designed for aggressive growth with significant exposure to equities were the hardest hit, according to research that tracked 17 automated platforms during the ugliest months of last year. The average growth portfolio was down approximately 1.5% annually.

“In general, this is not a surprise,” says Roi Tavor, CEO of the research firm Nummo that completed the survey of more than 300 investment portfolios. “The robos performed worse than previous years, which is in line with the industry as a whole.”

However, even as markets were at their worst, few robos experienced outflows. Nearly 60% of Americans expect to use a robo advisor by 2025, according to research by Charles Schwab. Forty-five percent of Americans think robo advisors will have the greatest impact on financial services — more than other forms of technology including cryptocurrency, blockchain and AI.

While automated platforms have not experienced a sustained downturn like the 2008-2009 financial crisis, they have had experience navigating heavy volatility.

“Our customers are smart and they tend to stay the course,” says a spokeswoman for the leading independent robo advisor Betterment. “We also know that’s much easier said than done and have built several behavioral guardrails to discourage knee jerk reactions based on market movements.”

The 2008 crisis was a historically serve recession, characterized by established banks failing or requiring aid, says Grant Easterbrook, founder of robo advisor Dream Forward. If the next downturn sees a “normal drop” without bailouts for financial firms, there will presumably be fewer panicked clients.

Without hand-holding, however, investors may be inclined to get out of the markets altogether, says Greg O’Gara, an analyst with Aite Group. The phones would likely start ringing at robos’ advisory call centers during a volatile market. If those clients don’t get the service they need, they could potentially liquidate assets.

“I would expect a potentially younger client base to be advised to stay in their portfolios for the long haul and not panic sell,” O’Gara says. “That said, if no one is there to man the phones, you could see increased selling.”

Clients may simply choose to migrate into less risky investment options such as cash. For example, Wealthfront and Betterment have recently added products, like high-yield cash accounts and bonds that yield more than 2% interest rates with little or no risk to investable assets.

Another natural evolution for robos in a downturn may be to turn to actively managed portfolios. Although predicated on passive funds, digital advisors may evolve to remain attractive to investors. “Competitor actively managed funds that may have underperformed in recent good years may suddenly look attractive if they can reduce losses in a bear market,” says O’Shea.

Either way, robos will need to offer more choices, says Will Trout, an analyst for Celent. They could offer differentiation and a fresh take on the market through impact and other themed strategies, for example.

“Just like Wall Street, some will use the next bear market to craft and sell new products designed to appeal to fear,” says Birk. “Some may see their business model suffer and those that are not true fiduciaries may pivot to higher fee approaches.”

Betterment CEO Jon Stein disagrees. Active management is not a panacea for slumping markets and actually undermines the mission of many digital investing platforms, he says. “I haven’t seen any evidence — and I’ve looked at a lot — that says active management outperforms in any certain market environment,” Stein says, adding active investment vehicles often underperform because of the additional fees. “There are lots of different philosophies on what will beat the markets.”

While investors may be comfortable with using technology for investing, the algorithms at the heart of digital platforms may be too predictive to ultimately be useful and could benefit from more active approaches to investing, says Allan Katz of New York-based Comprehensive Wealth Management. That’s because algorithms are ultimately backward looking and have very little ability to be predictive, he says. An asset class that performed well last year may slump the following year.